The latest move by the People´s Bank of China (PBoC) to devalue the Renminbi (RMB) by almost 2% remarks the biggest daily deprecation since 1994. While surprised by many investors, the exchange rate reforms are complementary with ongoing capital account liberalization measures. However, from this perspective, the RMB exchange rate will be more market-oriented going forward, and the volatility of the RMB – both in the onshore (CNY) and in the offshore (CNH) FX rate – will pick up in the current market conditions.

While the PBOC will likely use open market FX operations to try to reduce sharp volatilities and to avoid sharp capital outflows as the market starts to price in further depreciation potential, we do not expect a double-digit depreciation. However, we may see some further depreciation of the RMB vs. the USD going forward within the actual trading band of +/-2% - the daily trading price of the USD against the RMB in the interbank foreign exchange market is allowed to float within a narrow band of 2% around the central parity –, given the likelihood of divergent monetary policy unfolding between the Fed raising interest rates and PBoC seen easing monetary policy further (via e.g. an interest rate cut and cuts in the Reserve Requirement Ratio).

The International Monetary Fund (IMF) welcomed the PBoC's new exchange mechanism, although the Fund noted that the change has no direct implications for the criteria used in determining the composition of the Special Drawing Rights (SDR) basket. The IMF said further that the economy can and should aim to achieve an effectively floating exchange rate system in 2-3 years. Hence, a band widening would be the next logical step in a shift to a much more flexible exchange. More so, as the government recently talked about band widening explicitly as a policy objective. However, the Chinese government will want to wait until the new fixing methodology materialized and market expectations have stabilized before widening the bands, but it may happen earlier than the market is expecting.

On top of that, the perception of the risk premium regarding China and its currency may change, as China’s currency has been known as a steady and appreciation based currency over the past decade. This will lead to higher volatility per se as investors adapt to this new kind of environment. In terms of contagion, the volatility for other Asian currencies may raise as well in the foreseeable future. In particular, Asian currencies such as the Australian Dollar (AUD), the Korean Won (KRW), the Taiwanese Dollar (TWD) and the Singapore Dollar (SGD) are seen as being more sensitive to China's FX policy compared to other currencies in the region.

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